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Sunday, 18 October 2020

Foreign debt is leaving emerging markets more vulnerable to shocks than ever before

Foreign debt is leaving emerging markets more vulnerable to shocks than ever before: Widening private debt, rapid monetary expansion and low-cost lending have left emerging markets with a much larger challenge in piecing together an economic recovery from covid-19 than they did during the global financial crisis, according to a new study by the Economic Research Forum (ERF), which suggests the problem lies in the volatility of taking on foreign currency denominated debt and underdeveloped domestic financial markets.

Rigid lending terms place EMs in a bind when external shocks arise: Corporate bonds, which constitute the bulk of FX-denominated bond issuance in EMs, are at high risk of default during a crisis and are not subject to restructuring, Sarah El-Khishin and Mahmoud Mohieldin, the authors of the report, argue. Similarly, sovereign bond issuances, which middle and low income EMs are more likely to opt for given their underdeveloped financial markets, are just as risky because of restrictions on restructuring.

Long-term monetary expansion and cheap private sector lending has paved the way for corporate bond issuances and speculative financial activity to thrive in EMs. These policies, designed for short-term use, are being deployed as long-term growth strategies and have led to a situation that is “disturbing the connection between financial markets and real sector performance during the crisis.”

The solution? Emerging markets need to find the right balance between short-term external finance and more conservative growth targets. This would mean possibly forgoing medium-term growth by reining in loose monetary policies introduced during the pandemic, which the authors call “highly alarming.” More flexible exchange rates could also be deployed to shore up against external shocks and short-term speculative activity. As for our lenders, some “breathing room” like granting a moratorium on debt and promoting more options for restructuring could help protect against debt crises.

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